Saturday, 22 May 2010

A double-dip is not that sweet...

You cannot bring about prosperity by discouraging thrift.
You cannot strengthen the weak by weakening the strong
You cannot help the poor man by destroying the rich.
You cannot further the brotherhood of man by inciting class hatred.
You cannot build character and courage by taking away man's initiative and independence.
You cannot help small men by tearing down big men.
You cannot lift the wage earner by pulling down the wage payer.
You cannot keep out of trouble by spending more than your income.
You cannot establish security on borrowed money.
You cannot help men permanently by doing for them what they will not do for themselves.

written in 1916 by the Rev. William J. H. Boetcker, a Presbyterian clergyman and pamphlet writer

It becomes clearer and clearer that a risk of a double-dip recession is alive and well.

Equities have continued the trend down and credit risk has risen as well, as reflected by the current CDS market spreads.

"The cost of protecting against default on high-yield and financial companies rose today, JPMorgan prices show. Contracts on the Markit iTraxx Crossover Index of 50 companies with mostly junk credit ratings increased 13.5 basis points to 619. The Markit iTraxx Financial Index of 25 banks and insurers rose 5 to 174 and the subordinated index rose 15 to 265."

The risk is being priced in the market. Most of the risk indicators, CDS, VIX, Ted Spread and Libor-Ois are on the rise.

According to Jeffrey Miron in Street Talk in Forbes, the sign is ominous:

"The news that claims for unemployment insurance rose unexpectedly last week - and by the largest amount in three months - will no doubt spark fears of a double-dip recession. Most economic indicators point to a consistent if perhaps lukewarm recovery, however, so is double-dip really a possibility?

Yes, because policymakers in the U.S. and Europe are likely to choose the wrong approaches in responding to their fiscal imbalances. The U.S. has been adding expenditure (Obamacare) and may soon consider a VAT; Europe appears ready to monetize its debt rather than curtail excessive spending. So fear of higher taxes and inflation may discourage new investment and hiring, allowing the U.S. and others to slide back into recession."

Unfortunately, recent events have shown we can expect indeed a double-dip because our politicians are most of the time making the wrong decisions.

Angela Merkel's knee jerk reaction triggered a panic in an already very dysfunctional and nervous market. It was a very bad decision. By banning short selling on financial companies in Germany, it is as if Merkel is telling the market that there are some major poblems with these companies. Rather than alleviating the market's concern, it has had the complete opposite effect and exacerbated the ongoing sell-off.

"It was especially strange that her government also banned naked short-selling of shares in Germany's largest banks, which are heavily exposed to Southern Europe's sovereign debt. That can only make investors more suspicious of those ostensibly sound institutions.

Ms. Merkel needs to remind herself that "markets" are mostly made up of money managers doing their best to protect pension funds and other savings of ordinary people. She says that she is trying to rescue the euro, but excessive rhetoric stimulates a flight by investors to other currencies. She says she is trying to save Europe, but erratic action feeds the impression of a continental political class that may be losing its nerve and its way."

This another fine example of why a double-dip can be expected because of the complete inability of our politicians to grasp the complexity of the problems at stake and the wilingness to tackle rapidly and decisevely the structural imbalances which have plagued Europe due to lack of fiscal discipline and public spending restraints.

This is not a time for haggling. It is decision time. A time for reform, a time for public spendings cuts and review, in most of the European countries.

Some countries have already started acting, Ireland, Spain, Portugal. But, some countries have not really started the process, like France. France is just starting to "think" about following the steps undertaken by Germany a few years ago in relation to introducing specific rules relating to budget deficit in its constitution. This fine line was drawn in order to protect its citizen from politians, who, as we all know from experience, tend to drift towards a spending spree when elected. The UK is a good ilustration of binge drinking, but also in binge spending. Under Labour, in ten years spending on the NHS increased from 53 billions GBP to a massive 120 billions GBP in the budget.

Here are the details relating to Germany's introduction of the stability law as detailed by Wolfgang M√ľnchau in the Financial Times:

"From 2016, it will be illegal for the federal government to run a deficit of more than 0.35 per cent of gross domestic product. From 2020, the federal states will not be allowed to run any deficit at all."

"Anchoring the stability law at the level of the national constitution is an extreme measure – like locking the door, and throwing the keys away. It can only ever be undone with a two-thirds majority – and even a future Grand Coalition may not be able to deliver this as both of the large parties are in a process of secular decline. It means that future fiscal policy will be in the hands of the justices of Germany’s Constitutional Court."

"France has more or less followed Germany’s lead at every turn, but I suspect this may be a turn too far. Deficit reduction has not been, nor will it be, a priority for Nicolas Sarkozy, the French president."

The issue is that France doesn't have the luxury (apart from its industry...) to postpone anymore structural reforms similar to the ones undertaken by its closest business partner.

Unfortunately, the political system in France make the country very difficult to reform. Politicians are moving from one election to the next and cumulate various electoral mandates which means, that their interest is never aligned with the best common interest as they move to one election to the next, buying votes on unrealistic promises (35 hours week, etc.) by issuing more debt, and increasing in the process the already crippling burden of the debt.

The only way to reduce the debt levels is by starting first to balance the budget. It is a simple question of accounting principle but very unpopular with politicians.
Austerity is a foul word in France but it is has become critically urgent as well.

I agree with Wolfang Muchau relating to Sarkozy's lack of willingness in tackling deficits. Given Sarkozy is already thinking about the oncoming elections of 2012, you cannot expect decisive structural reforms to be undertaken. I expect a Socialist government will be elected in 2012, probably led by current IMF president Dominique Strauss-Kahn. It will be easier for a Socialist government in France to led the reforms, although to some it might appear completely counter-intuitive.

Where I completely disagree with Wolfgan Muchau is on the following:

"While the balanced budget law is economically illiterate, it is also universally popular. Average Germans do not primarily regard debt in terms of its economic meaning, but as a moral issue. Der Spiegel, the German news magazine, had an intriguing report last week on the country’s young generation. One of the protagonists in its story was a young woman who had borrowed a little money to set up her own company. The company turned out to be a success, and she had began to repay the loan. And yet she said she had not felt proud of having taken on debt.

This general level of debt-aversion is bizarre. Many ordinary Germans regard debt as morally objectionable, even if it is put to proper use. They see the financial crisis primarily as a moral crisis of Anglo-Saxon capitalism. The balanced budget constitutional law is therefore not about economics. It is a moral crusade, and it is the last thing, Germany, the eurozone and the world need right now."

Having a balanced budget dear Wolfgang is not economically illiterate, it is not only a moral issue but also it is the right thing to do for a government. It is a matter of responsibility for the government. Having a balanced budget reduces the risk of inflation and monetizing debt.

If the young generation of Germans regard debt as morally objectionable to some extent, there is hope. The protection given by the stability law is as well a deterrent to politicians tendency of spending more what a country can afford. Canada has had the right attitude in tackling its public spending and reducing its debt level very successfully. It can be done.

The most worrying part in today's turmoils is the current tussle between Germany's willingness to impose strict fiscal discipline in the Eurozone which does not coincide with France political agenda.

This creates a risk for a Euro break up. It is a fight between the disciplined members of the Eurozone and the lesser ones such as Greece, Italy and France.

As pointed by Professor Nouriel Roubini in Daily Finance, "Politics are now the main problem".

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